An adventure in Indian Pharma : A comprehensive guide for the new investor

Summary: Globally the Pharmaceutical and Life Sciences sector has shown resilience in the market meltdown. In India too the Pharma Index has broken past multi-year resistance and is poised to reach new highs. What is driving the sectoral bull run ? What are the unknowns and risks for an investor new to the sector ? I answer these questions and also give a framework for investing in Pharma companies.

Pharmaceuticals : Unique risks

The most important note for a new investor to Pharma is that the sector has unique characteristics:

  • Regulated : Like banking, Pharma is a heavily regulated industry with compliance requirements that are unique to each geography. However, regulations in Pharma are a greater source of risk than banking because the costs of non-compliance do not just include fines but involve enforcement actions by regulators like the USFDA and the UK based MHRA such as blanket bans on production facilities. These enforcement actions can create serious balance sheet risks by rating production facilities producing multiple approved drugs as non-compliant and putting all production and exports from the facilities indefinitely on hold.
  • Product to Market lifecycle : There is no sector where the length of time and costs involved to bring a New Chemical Entity (NCE) to actual market are as prohibitive as Pharma. The time can run into decades with average costs of up to $500 million. For contrast, defense equipment manufacturers also have decades of product development (Say for a fighter jet like the Rafale) but can rely on support of local governments and foreign markets. For pharmaceutical companies there are no guarantees, backstops, forward orders or support from authorities. Regulators can at any stage in the lengthy process derail an investment in a drug as unsuitable or unsafe and lead to a costly write off. This is particularly true of Indian companies with markets abroad. The marketplace may also change in the interim long period, or new competing therapies may become available. This causes financial risks in the form R&D sunk costs (which can be as much as 15% of a company’s topline), opportunity costs and also balance sheet risks.
  • Value Chain : Because most complex formulations require a prescription the pharma value chain is complicated by many stakeholders – such as groups of buyers, pharmacy chains, marketing field force, doctors and even chemical ingredient and intermediary manufacturers in China. Any consolidation in any section of the value chain can increase or decrease bargaining power and change the margins for the drug formulation manufacturer. Often the developer of the drug is not the manufacturer (where manufacturing is contract based or outsourced by the drug owner) and often the marketing company (which could be a different pharma company altogether) could be different from the company that produces or owns the drug. These factors introduce new and unknown risks. A drug that seemed viable at discovery may become economically unviable due to changes in the value chain.

Given the above unique characteristics that drive unique risks and their complex interactions, and in full honesty to my readers : Pharma is a sector best invested in via a sector specific mutual fund led by fund managers with deep experience in tracking the sector and their individual companies

Pharmaceuticals: Unique Rewards

Just as the sector has unique risks, it offers unique rewards to those direct investors who may choose to persevere recklessly to master its complexities.

Global play: Like IT and Auto parts, the Indian Pharma sector is a major exporter to developed countries (and underdeveloped continents as well). But unknown to many it is much more integrated into the global industry than IT and embedded much higher in the value chain, all the way to owning marketing of its own branded generics formulations (the point of maximum returns). Coupled with foreign exchange realizations, this gives it access to good margins and market size.

Barriers to Entry: Although most Indian Pharma companies do not produce IP protected formulations but produce generics versions of drugs that have come off patent, jumping through the many hoops of regulatory approvals, quality inspections and negotiating with the value chain partners gives them a strong barrier to entry. Competencies take years to build and so the barriers to entry in Pharmaceutical formulations are much higher than Pharmaceutical ingredients, which in turn is higher than those in specialty and bulk chemicals (such as those used in pesticides). To illustrate, if a producer of specialty chemicals chose to enter into pharma – it would need to meet myriad quality and regulatory requirements and find alliance partners in the target country

Non-cyclicity: Most listed companies in India have a cylical business, with peaks and troughs in demand through time. IT services, auto and believe it or not, financial services are cyclical as well. Pharma is one of the few spaces where you can park money without a fear of broader Industry seeing a lull in demand. This is especially true of chronic therapy portfolios like diabetes and heart disease. Non-cyclical industries in general command higher multiples and can prove to be rewarding long-term investments.

Pharmaceuticals: Every company is different

Naturally, pharma companies must reflect the specializations and unique complexities of the underlying diseases or conditions they try to address. While this is true of all sectors, in Pharma the variance between company profiles is much broader than sectors offering more commoditized products or services.

In general, companies vary by;

  • Product portfolio –
    • Value chain product – drug formulations, active pharma ingredients (APIs) or downstream chemical intermediaries
    • Complexity – drugs can be complex like injectables, radio pharmaceuticals and respiratory inhalers or simple like over-the-counter cough syrups or pain medication
    • Chronic or Acute – chronic therapies like diabetes and cardiovascular disease or acute like pain management and anti-infective drugs
  • Geographies served – India-focused, US-focused, EU-focused, Africa, Latin America, Japan – you name it, Indian companies are everywhere. The geographical strategies adopted by Indian companies may vary broadly. For example, small cap Marksans Pharma (NSE: MARKSANS) focuses entirely on US/UK/Australian geographies with no Indian presence; while similar sized companies like Jenburkt Pharma or RPG Life Sciences are focused on the domestic Indian markets. Companies like Caplin Point Laboratories (NSE: CAPLINPOINT) focus on the South American market for most of its revenues. The fortunes of these companies will naturally follow the idiosyncrasies of the particular focus geography (which is also why, larger companies that are geographically diversified often make safer investments).
  • Size of operations – in general big pharma is very different in scale, portfolio quality and quantity from small pharma companies. For example Big Pharma companies can afford to have an experimental Biologics portfolio and larger R&D outlays, in part because they are more certain of market access and success due to scale and experience. An example is Sun Pharma’s research wing – SPARC, which focuses on drug discovery. If successful, the drugs are developed and marketed by Sun Pharma (which keeps the profits and shares the royalties with SPARC).

Apart from the above, the pharma companies in India can be organized by tiers. Generally market cap is a good proxy for the quality of product portfolios in this industry.

Rule of Thumb: Large cap pharma companies can be reliably assumed to have more NDAs (new drug applications) filed and approved in India and abroad than Mid or Small cap companies. They will also have more complex and diversified portfolios.

If we were to arrange the companies into tiers, they would look as shown below –

Tier 1 companies – the Lamborghinis: Sun Pharma, Biocon, Lupin, Aurobindo Pharma, Dr Reddys Labs, Cipla

Tier 2 companies – the BMWs: Glenmark, Jubilant Life Sciences, Torrent Pharma, Abbott (Indian subsidiary), AstraZeneca (Indian subsidiary)

Tier 3 companies – the Hondas: Natco Pharma, Alembic Pharma, Shilpa Medicare, Caplin Point Labs

Tier 4 companies – the Fiats: Laurus Labs, Neuland Labs, Albert David, Jenburkt Pharma

Tier 5 companies – the Golfcarts: Lincoln Pharma, Anuh Pharma, Sakar Healthcare, Tyche Industries

You don’t want to ride this

What happened to Pharma these past few years ?

Debt piled up when the Pharma Index peaked in 2015

In the Trump Era, regulatory actions and Value Chain consolidation eroded the profitability of generics drugs in the USA. Competition among generic players also intensified and due to locked capital investments – balance sheets of big Indian pharma companies took a hit as debt from new investments piled up with no pay back in sight. Many of these investments had to be written off (e.g. recent Dr Reddys Q420 results) or sold to raise cash (e.g Jubilant contemplating sale of its portfolios and demerger of some entities).

The Pharma Index peaked in 2015 and has been in a downtrend ever since .. until recently

Due to decline in prices from value chain consolidation, competition and increased regulatory actions, Indian Pharma companies responded with changes to their strategy :

  • Focused away from regulated markets (US, EU) to unregulated / less regulated markets (South America, Africa, Russia and CIS states)
  • Increased their India portfolio and exposure
  • De-bottlenecking of existing capacities to save on operational costs
  • Rationalize portfolio of drugs to focus on scale and margin protection

Anticipating increased regulatory action and reducing margins, one strategy of Indian Pharma companies has been moving from basic generics formulations into advanced formulations (injectables, gelatin dosages, inhalers, complex drugs etc.). The other strategy has been to increase exposure to the domestic Indian market.

As recently as February 2020, Dr Reddy’s – which is listed on NYSE – bought Wockhardt’s South Asia plant and product portfolio. Andhra based Natco Pharma even began to explore getting into adjacent industries like agrochemicals to protect its margins.

Since the top in 2015, Indian Pharma companies have been on the defensive – then the Pandemic happened.

Change in Fortunes

The surge in global demand for the anti-malarial drug Hydroxychloroquine (better known as HCQ), Azithromycin and Paracetamol have put Indian Pharma companies in spotlight once again. This short term driver has also led to temporary regulatory forbearance from the USFDA for other, unrelated drug applications that were in pipeline.

Further, Value Chain disruptions from China, which is a major producer of bulk drugs/intermediaries and APIs – raw materials for Indian and global pharmaceutical formulations companies, will drive longer-term trends. Near-sourcing of drug production by US / EU regulated markets or a shift to alternatives like India and Vietnam will happen in the coming years.

However, in terms of scale, experience, sophistication and access to global markets – no country comes close to India. There is no competition.

Well poised – Indian companies have a 35.8% share of the US generics market

To summarize, the euphoria in the Pharma counters is not entirely speculative and is driven by the following factors:

Short term drivers –

  • Temporary regulatory forbearance from the USFDA
  • Demand for HCQ and Azithromycin
  • No impact of lockdowns as Pharma is an essential industry – the market likes certainty of earnings

Long term drivers –

  • Increased market share of downstream API, bulk drugs and generics formulation (shift from China)
  • Increased spending on Healthcare (hence higher multiples to Pharma companies)
  • Strategic shift: More optimized portfolios, costs and diversification of portfolios undertaken since 2015 put pharma companies on a good footing
  • Price erosion in simpler generics to continue, however opportunities in complex generics and new therapies such as Biologics may lead to higher possible returns

The Beginning Pharma Investor: A Framework

Now that we have listed out the drivers of the bull run, I define a framework to minimize yours risks of investing in Pharma companies.

FactorDescriptionMetrics (check for)
Strength of Balance SheetPharma is a capital intensive business and unique risks give rise to balance sheet riskAltman Z Score > 3
Capital AllocationDue to the constantly changing risk and reward landscape, capital allocation is a critical skill in pharma and also a barometer of management quality in picking the right opportunities and avoiding the pitfalls. ROCE or Return on Capital Employed can be studied through the cycle (from 2014 to 2020)3-year average ROCE > 10%
AND
6-year average ROCE > 15%
Mutual Fund HoldingQuality pharma companies with growth potential will be held by foreign or domestic mutual funds Institutions hold > 5% of public shares
R&DQuality pharma companies will spend on R&D as they look to develop more complex APIs or formulations that lead to more sustained margins5-year average R&D as a % of sales > 3%
ValuationGiven the uncertain cashflows and active deal books in pharma, EV/EBIDTA informs us of the relative valuation or acquisition multiple for the pharma company better the P/E or other metricsEV/EBIDTA < 25
Portfolio QualityGreater chronic portfolio v/s acute leads to less competition and more sustained pricing power10% or more of sales is in Chronic drugs or APIs
Evaluate each company on this scorecard

Apart from the other quantitative metrics one should also evaluate qualitative metrics:

  • Trend of regulatory actions in the past-5 years: Have regulators frequently handed out bans and enforcement actions over quality of production processes and data? Has there been an improvement in compliance since 2015? Old habits die hard and this is an important barometer of a Quality Conscious management.
  • Diversification: In an uncertain industry, the more legs to stand on the higher the staying power of the company and safer your investment. Questions we must ask during the investment process –
    • How embedded is the company across the pharmaceutical value chain – APIs, contract research, marketing teams, foreign production facilities, alliances ?
    • How much do raw material risks impact the company’s profits ? A formulations company that produces its own active pharmaceutical ingredients has a unique cost and stability advantage in post-coronavirus world.
    • Others like Biocon or Dr Reddys Labs do well by focusing on formulations and procuring their raw materials. They have diversification benefits by geographical presence and value chain activities (such as Biocon’s contract research and manufacturing divisions in Syngene, or DRLs growing Rest of World and Indian portfolio)

Conclusion: In sum, pharmaceutical companies are the leaders of the current bear market rally and the rally may have just stretched its long legs. While investing in Pharma seems lucrative it is important to understand the risks and rewards and study the unique profile of each company to see how it is placed for growth in a changing world. For further discussion, happy to take your questions. Please leave a comment or DM me on twitter.

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